Actuaries’ Responsibility to Users of Their Work Products CAS Spring Meeting

1. May 19, 2003 Actuaries’ Responsibility to Users of Their Work ProductsCAS Spring Meeting Chad C. Wischmeyer, FCAS, MAAA, CFA Mercer Risk, Finance and Insurance Consulting Cara M. Blank, FCAS, MAAA OneBeacon Insurance Companies Mary D. Miller, FCAS, MAAA Ohio Department of Insurance Thomas M. Mount, ACAS, MAAA A.M. Best Company

2. Introduction

3. Actuaries and Actuarial Reports are Under Increased Scrutiny WHY? • Increased concern over companies financials • More people discover actuaries and the benefits they can offer • Less cushion for adverse reserve development • Litigiousness • Society at large • Plaintiffs bar has found the actuarial profession

4. Speakers • Cara M. Blank, FCAS, MAAA Vice President and Regional Actuary OneBeacon Insurance Companies • Mary D. Miller, FCAS, MAAA Actuary Ohio Department of Insurance • Thomas M. Mount, ACAS, MAAA Managing Senior Financial Analyst/Actuary A.M. Best Company

5. The Actuary’s Relationships with Users of a Work Product Discussion Paper Prepared by Committee on Professional Responsibility

6. Scope • Code of Professional Conduct Prevails • Offers explicit guidance concerning principals • Less explicit with regard to third parties’ interests • Not binding – intended to generate discussion

7. Code of Professional Conduct “The purpose of [the code] is to require Actuaries to adhere to the high standards of conduct, practice, and qualifications of the actuarial profession, thereby supporting the actuarial profession in fulfilling its responsibility to the public”

8. Precept 1 –Professional Integrity “An Actuary shall act honestly, with integrity and competence, and in a manner to fulfill the profession’s responsibility to the public and uphold the reputation of the actuarial profession” • Use skill and care • Refuse services to those that may use services to avoid the law or damage actuarial profession • Shall not improperly use relationships with third parties • Shall not engage in any professional conduct involving dishonesty, fraud, deceit, or misrepresentation

9. Components of the Code • Professional Integrity • Qualification Standards • Standards of Practice • Communications and Disclosure • Conflict of Interest • Control of Work Product • Confidentiality • Courtesy and Cooperation

10. Myths • Code of Professional Conduct is only important for actuaries who: • Set reserves • Testify under oath • Advise policymakers • Consult • Only actuaries engage in the above activities

11. Complex Situations

12. Actuarial Roles in Practice • Operations Research & Development • Creating new rating or product plans • Financial Accounting/Reporting • Reserving, public reporting, company valuations • Regulatory/Statutory Compliance • Filings, solvency exams • Regulatory/Statutory Influence • Policy or standard setting • General Management • General business practices

13. Changes in Landscape • Senior management accountability • Increasing number of public companies • Organizational structures have changed • New players • Higher educational levels • Rate and product deregulation in certain state markets increases actuary’s accountability for results

14. Less Complex Situations

15. Are all services performed by actuaries “actuarial”? What if users do not understand the work or understand it differently than intended? Can I change my approach depending on the principal’s needs? What if the law conflicts with the standards of practice? Situations

16. Benefits Provides process of self-regulation Provides guidance on numerous practice areas Provides sound guidance on means of ensuring proper use and interpretation by users Consequences Focuses on actuarial science; expanding credentials may require additional sources of accreditation Not all actuaries qualify for the same types of practice Implications of the Code

17. Observations of an Insurance Regulator Actuarial Opinions

18. Actuarial Opinions: Whose fault is it? • “Not I!” said the CEO, “I had a ‘clean’ reserve opinion so I thought everything was OK.” • “Not I!” said the Insurance Commissioner, “their actuary gave them a ‘clean’ opinion so I thought everything was OK.” • “Not I!” said the Actuary, “I relied on management to give me good data and to tell me whether their reinsurance was collectible or not. I also relied on the auditors and the state regulators to find any problems. It’s not my fault. I did the best with what I had.”

19. Actuarial Opinions: A look back in time • Statutory opinions born out of insolvencies of the 1980’s. • Originally said reserves made ‘good and sufficient’ provision for reserves. (Life and Health opinions still do) • Now they make a ‘reasonable’ provision – Is that enough? • Yes, as long as reasonable does not mean “I can make the numbers come out that way if I try hard enough.”

20. Actuarial Opinions: To whom do we owe a responsibility? • All things being equal, everyone’s best interests are served when companies are solvent and reserves are adequate. • Actuary needs to report the results of his/her review thoroughly and honestly to the company’s Board and management, identifying risks and areas of concern. • Management books their best estimate and the actuary communicates their evaluation of that estimate to the domiciliary Commissioner by way of their opinion.

21. Actuarial Opinions: How do we fulfill our responsibility? • Communication to the Board, management and domiciliary state must be forthright. • Reasonable must mean more than “if all the most optimistic assumptions come through.” • A healthy dose of skepticism is essential – more reserves develop adversely than redundantly.

22. Actuarial Opinions: Where can we go for Guidance? ASOP No. 36 gives us several excellent tools for communicating through the Opinion • Defines 5 Types of Opinions • Significant Risks and Uncertainties Paragraph – Minimal boilerplate, PLEASE!!!!! • Risk of Material Adverse Deviation • Gross vs. Net Reserves • Range of Reasonable Reserve Estimates

23. Actuarial Opinions: How can the regulator help? • We are trying to see that the mechanisms and protections are in place to help you succeed. • New Audit Instructions will require communication with the actuary and testing of the data he/she relies on. • New opinion and report instructions will try to protect confidentiality of regulatory communications.

24. Actuarial Opinions: What do they expect an Actuary to do? • Take responsibility for your work product • Decline the appointment if you are expected to be less than honest. • Sarbanes-Oxley makes today the best time to get off the slippery slope and onto solid ground. • Actuarial knowledge and judgment are valuable tools – use them to strengthen the profession one actuary at a time.

25. Using Actuarial Work Products in the Rating ProcessReliance on Actuarial Reports

26. Outline • Impact of Reserve Deficiencies • What products used • Why or why not used • How products used • Helpful exhibits • Pitfalls • Conclusions

27. Impact of Deficiency on Rating Process • Materiality • ASOP 36 - Statement of Actuarial Opinion regarding P/C loss & LAE reserves • Consider purpose and intended use • Ratio to surplus • Ratio to premiums • Ratio to carried reserves • Ratio to net income

28. Impact of Deficiency on Rating Process • Should we consider impact on Financial Strength Rating in materiality? • Yes • Deficiencies are extremely important • Even small deficiencies can contribute to downgrade • Can be compounded by growth charges • Deficiencies funded from surplus have impact on economic surplus and required capital

29. Documents used to Estimate Deficiency • Schedule P • Reserve Opinion • Actuarial Report supporting Opinion • Quarterly Financial Statement - Part 3

30. Why or Why Not Used • Schedule P • Readily available source of data for development • Reserve Opinion • Opinion stating “reasonable provision” not Used • Used to gain other info about the company’s reserves

31. How are we doing?

32. How are we doing?

33. How are we doing?

34. Why or Why Not Used • Actuarial Report • More detailed Commentary • More detailed Analysis • Greater understanding of trends • Shows assumptions used • Quarterly Financial Statement • Part 3 gives quarterly updates on prior year reserve development

35. How are Documents used? • Schedule P • Used to generate A.M. Best’s indicated ultimates • Used to generate deficiencies • Used to generate credibility • Used to calculate reserve discount factors • Report card of company’s ability to reserve adequately • Reserve Opinion • Relevant comments used, including discounting, retroactive reinsurance, salvage/subro treatment, major risk factors, change in methods/assumptions

36. How are Documents used? • Actuarial Report • Commentary may provide reasons why Sched P not appropriate • Case reserve strengthening • Change in settlement rates • Review Analysis for • LDF selections • Ultimate selections • Pd/Pd selections • ELRs used • Freq/Severity Trend and other Assumptions • Methods used • Quarterly Statement – Part 3 • Watch prior year development

37. Helpful Exhibits in Actuarial Report • Historical Selected Ultimates/Runoff by AY • Historical Net Retentions by AY • Calculation of ELR • Show earned rate changes • Show freq/severity trend selections/support • Average Severity - selected & reported triangle format • Average Case reserves – triangle format • Closing Rates – triangle format • Pure Premiums

38. Pitfalls in Actuarial Reports • Trends in LDF’s – responsive vs stability • 1.10, 1.15, 1.20, 1.25, 1.30 • Should select 1.35, but reports using 5 yr ex hi,lo , 3 yr avg, 5 yr avg understate ultimates • Curve fitting severities – responsive vs stability • Using Accid Qtr data when Accid Yr available and growth not an issue • Using ILFs when credible total limit data available • Selecting based on “judgment” without stating reason • When using/citing industry data, show it

39. Summary • Reserving is a corporate philosophy • Reserve deficiencies are material to rating process • Amount and extent of adverse development is too high • Only saw 2 adverse Opinions – one high, one low • Need to reduce the number of companies with adverse development and reduce the extent of adverse development to maintain profession’s credibility • Even though filed Actuarial Opinion is ignored, our interactive rating process does value the actuary’s expertise and is considered in the rating process.